Posted by on January 3, 2015

I lead a sad life in many ways.  Which explains why I was up at 6am on January 1 flipping through the Forbes 400 list of the wealthiest Americans looking for the role of finance in the American economy.  Here is the link to the list if you are equally pathetic.

In a completely unscientific, but nonetheless highly accurate (I insist), survey, I went through the list identifying those who had made their money in finance.  Unfortunately, Forbes doesn’t make this easy since the sorting toggles on their list are both incomplete and inaccurate.  But this doesn’t surprise me.  The people who work for magazines like Forbes and Fortune are typically not encumbered by any real knowledge of the subjects which they cover.

Here are some rules that I used:  If you are a “hedgie”, a hedge fund manager, you definitely made my list; this was already a depressingly large number.  If you made your money in banking or a lending business (eg., Dan Gilbert of Quicken Loans), you made the list.  If you are in an industry that directly serves Wall Street (eg., Bloomberg News), you made the list.  If you are a private equity manager, although not necessarily a member of one of their management teams, you made the list.  If you are a venture capitalist, you made the list – although this is one area where I was perhaps a bit harsh, since I suspect that the really good venture capitalist are actually very industrial in their approach (although this may just reflect my naivety about the way that Silicone Valley really works, where the ability to “give good lunch” also appears to be a major factor).  If you are in money management (eg., Bill Gross from PIMCO), then you stood up and were counted.

But you didn’t make the list if you are in insurance (unless your first name is “Warren” and you only do insurance as a sideline), since I considered this to be a real business unaffected by the distortions I will discuss below.  Real estate didn’t put you on the list, although this is almost always a handmaiden of finance.  (I also had to find grounds to exclude myself – of course.)  You didn’t make the list if you are an heir to the Cargill fortune, even though this firm probably trades more financial assets than grains of corn these days.  You also didn’t make the list if you were someone like Edward Lampert, the CEO and major shareholder of Sears, who was a Goldman Sachs trader before buying into this company; although he looks pretty financial, I gave him credit for being an “industrialist” because his biography says that he spent his childhood stocking warehouse shelves and that he survived a two-day kidnapping, which has to be worth something.  And if you are a transplanted Russian oligarch, you didn’t make the list, even though your larceny skills are certainly related.

The end result was 79 names, or just shy of 20% of the total.  The percentage is more impressive because the Forbes list includes a bunch of people (the heirs of the Walton, Bass, Mars, Pritzker, Cargill, etc., fortunes) who made their money being members of the lucky sperm club.  If you excluded these people and focussed on the self-made, then the percentage would probably rise to about 25%.

Now, in a free-market economy there would always be room for financiers among the wealthy, but 25% seems like an awful lot to me.  For someone who advocates laissez faire, these results are disturbing for a whole variety of reasons.

As I have argued before (notably in “Jamie and the Whale” and “The Lady Doth Protest Too Much, Methinks”), we have a financial services sector that is bloated way out of proportion to its contribution to society.  Although finance in a free market economy should play an extremely important role in the allocation of capital – the “God’s work” famously invoked by Goldman Sachs’ Lloyd Blankfein — our current financial system, and Goldman Sachs especially, does much more wealth transfer than creation.  I know this from the inside.  I can also summon up again no less an authority than Paul Volcker, former Chairman of the Federal Reserve and one of the few truly wise and uncompromised voices in finance.  His quote bears continuous repeating: “The only thing useful banks have invented in 20 years is the ATM.”  Here is the link to his diatribe on the financial services sector that contains this truism.

Not surprisingly, with such good odds of ending up in the Forbes 400, finance sucks in much of the young talent of our country.  This is an enormous waste, as is shown by the career of someone like Jeff Bezos, who started out on Wall Street but who fortunately left to start Amazon, thereby eliminating the need for me ever to go shopping again.  It is also an enormous waste of resources when, as Michael Lewis tells in Flashboys, the company Spread Networks spends $300 million to lay a 827-mile fibre optic cable in the straightest possible line between New Jersey and Chicago so that high frequency traders can cut order times from 17 to 13 milliseconds.  A 4 millisecond saving that equates to one-tenth of the blink of an eye.  Although market liquidity and fast execution are generally good things, I can assure you that there is no public benefit to this investment and probably a lot of private evil.

It is also very disturbing to see the prevalence of hedge and private equity managers in my list.  There are doubtless some talented traders and financiers in this bunch, who do generate societal value by allocating capital and making companies run more efficiently, but they are much, much rarer than the current size of these industries would suggest.  The good ones also quickly amass enough money under management that their small-scale ability to add value quickly converges to large-scale mediocrity.  Not surprisingly, academic studies consistently show that, on average, hedge and private equity funds are losers for their investors.  The managers, however, benefit from a “heads I win, tails you lose” fee structure that frequently earns them a place on my list.

But the rot doesn’t end with the waste of human and other resources.   As I have argued before in ““Makers” versus the “Takers””, much of the current political noise about inequality is really outrage at the source, rather than the magnitude, of the discrepancy.  There is a strong and largely deserved belief that not only is the wealth gap becoming greater, but much of it is also undeserved.  Fortunes based on finance are rightfully viewed as particularly suspect.

The next question is, what is the cause of this “financialization” of the US economy, to use the word coined by David Stockman, the former Congressmen and President Reagan’s head of the Office of Management and Budget?  If I were a Marxist, it would be easy to answer this question.  Marx identified “financial capitalism” as the last gasp of our system.  But since Marx has been wrong about absolutely everything else, I see no reason to credit this prediction.   We must look elsewhere.  And, as is my wont whenever it comes to an economic evil, let’s start with the role of the government.

One cause is clearly the monetary policy pursued by the Fed since at least the Asian financial crisis in 1997.  Since this time, the Fed has pursued progressively looser money, culminating in the zero interest rate policy (“ZIRP”) and “financial repression” in place since 2008.  This has created finance-based inequality in two ways.  The first, as I have commented before (in “Furor Teutonicus”), is the explicit Fed goal to create a “wealth effect” by inflating asset values.  Since many of the people on my list are paid based on the value of the assets they manage, this policy has made them much wealthier through no fault of their own.  The one-sided nature of their compensation – benefiting disproportionately from bubbly asset prices, while never bearing the full brunt of their subsequent decline – has made this Fed-induced rollercoaster an enjoyable ride for them.

But the second way is probably more important.   The low interest rates and financial repression pursued by the Fed have made savers desperate.  In the absence of conventional investments generating a fair return, they have increasingly turned to “alternative investments,” such as hedge funds, private equity and venture capital.   The assets invested in these sectors have exploded which, when combined with their very lucrative fee structures, have propelled many of their managers onto my list.  It is no coincidence that the assets under management (“AUM”) in the hedge fund industry have grown from $118 billion in 1997 to $2.4 trillion currently.  Nor is it a coincidence that, even after the industry’s dismal performance in the financial crisis totally belied the “hedge” part of its name, leading to a temporary drop in AUM, assets have almost doubled during the era of Ben Bernanke’s and Janet Yellen’s “financial repression”.

Government policy has contributed in other ways, too.   Some of the most lucrative things you can do in finance are driven by the desire to circumvent government regulations in the continuous cat and mouse game I described in “Doping and Banking”.  This is a major base of the derivatives industry, particularly the much more profitable “bespoke” trades.  The non-sensible rules applicable to pension funds are another factor contributing to the growth of the alternatives sector.   Pension liabilities are like any other liability of a company or a governmental entity, and they should be evaluated at the cost of debt, not by using some artificial assumption of expected investment returns.   This practice forces pension managers into alternatives, and other risky assets, in an attempt to justify the high discount rates used to value their liabilities – if they held only lower risk and lower return assets, even the accountants would start to smell a rat.  Pension funds are the biggest source of the money that has propelled so many hedge, private equity and venture capital managers onto my list.

But try as I might to lay this entire noxious phenomenon at the feet of government, I can’t quite get there.  I can’t explain, for example, why a free market allows a $2.4 trillion dollar hedge fund industry to exist with such a blatantly one-sided fee structure.  I can’t explain why investors pour more and more money into a small number of large private equity managers which are clearly just playing the stock market, with leverage.   Or why shareholders in public companies sometimes allow CEOs to make my list, more through luck and stock market bubbles than through any real addition to corporate value.  These all fall into the economist’s catch all of “agency problems”, which are often made worse by government action, but which cannot be wholly explained by this.

Perhaps we just have to get used to a free market that is, to paraphrase Winston Churchill, the “worst form of (economy) except for all those other forms that have been tried from time to time.”  Still, I would sleep better at night if I could implicate Washington more fully.  I therefore welcome suggestions from my readership on other ways in which government policy has promoted “financialization”.  The prize for the best suggestion will be a free subscription to this blog.

Roger Barris, London

 

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Posted in: Finance, Policy

Comments

  1. Mary Lou Zangerle
    January 4, 2015

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    This is your best work – so far.

    • Roger
      January 4, 2015

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      Thanks, Mary Lou. Glad to hear this from someone who knows whereof she speaks.

  2. karl kiser
    January 5, 2015

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    This was very insightful. I hadn’t thought about this before, but certainly, those who “create” or “make” things/stuff/processes are the real job creators and economy “expanders.” Thanks.

    • Roger
      January 6, 2015

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      Don’t get me wrong, Karl. There is certainly a role for financiers in a free market economy and if they do their job properly, they add significant value to society by making sure that savings are channelled into productive investments and acting as a discipline on management teams (which can often forget that company resources are not their private property). Even the much maligned “speculators” can serve a very valuable function. Imagine how much waste would have been avoided if speculators had been effectively able to “short” house prices or sub-prime lending in 2004, 2005 and 2006; this would have served as a very important signal to the US economy that it was wasting resources by building housing that would not never cover the cost of the resources used to construct it.

      So, financiers have a role, but it is clear that we have taken this too far and they are often incentivized not to pursue their legitimate role in a free market economy. The second part of this statement is almost always the result of bad government policy. The first part, however, remains a bit of a mystery to me.

  3. Jim Clemence
    January 20, 2015

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    Roger, great read as always. I think the main reason institutional investors don’t discipline managers is because of their need to maintain access to management, not to acquire inside information (by the technical definition), but to take the mood, get the hint, nod, helpful explanation… Consequently large investors can’t discipline managers or they lose access. The only way to make shareholders discipline managers properly is to eliminate these private information flows. Get rid of the one-on-one investor meetings, nods winks and all – permit public meetings only between investors and management, whether actual or online. It might reduce efficiency of pricing through an overall reduction in information flow but the gains would be immeasurably bigger – properly functioning governance. Corporate governance failure is often portrayed as an inevitable flaw of the free market model rather than the solvable insider problem it actually is and leaving this problem unsolved is putting the free market system at risk. One of the benefits of making public markets work better would be that investors would have less need to invest in private companies through those thieving private equity managers. You’re right about hedge funds- I just don’t know why people invest in them. I’d rather lose money in the public market on something that is transparent and without paying the skewed fees. At least Calpers and PFZW have the right idea withdrawing their hedge fund allocations.

    • Roger
      January 20, 2015

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      Jim, a great observation — I expected no less — and something that I haven’t thought about before. The observation and your proposed solution are both totally on point. Ironically, I am just reading an article on Tesla, the US manufacturer of electric cars, where the author is making the point that, after some very bizarre comments from the wunderkind (heavy irony intended) CEO of this company at the Detroit auto show, the sell-side analysts and the major investors have reacted in a way that indicates that they have probably benefited from some private winks and nods. I agree that this should stop. The loss in informational efficiency will be nothing compared to the reduction in agency costs and the reduction in political opposition to free markets.

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